The Wrong Way to Pick Value ETFs

How to pick a good ETFU.S. News & World Report laundry-lists their top 10 “value investing funds,” or value investing exchange-traded funds (ETFs), in a recent article, “Best Fit Value Funds.”

The criteria (and weighting) for selecting so-called “value” ETFs are outlined below:

  • Expense Ratio (30 percent)
  • Tracking Error (30 percent)
  • Bid/Ask Ratio (20 percent)
  • Diversification (20 percent)

The criteria seem reasonable enough—at the outset. For example, expense ratios are clearly important, and all else equal, lower is better. No qualms here.

But the other criteria don’t make any sense in the context of active investing, especially value investing.

Tracking Error:  the volatility of the spread in returns between a benchmark and a strategy.

  • Minimizing tracking error is akin to maximizing “diworsification.”
  • Non-closet indexing funds are penalized?

Bid/Ask Ratio: measure for how much the ask exceeds the bid; a measure of liquidity.

  • ETF liquidity is primarily driven by the liquidity of the underlying securities the ETF holds.
  • So distress security funds—sometimes referred to as “value” funds—are penalized?
  • A phone call to an ETF trading desk that will offer you $50,000,000 liquidity at a one-penny spread doesn’t matter?

Diversification: Typically measured by the number of securities held in a portfolio and/or exposures to various sectors/industries.

  • Charlie Munger, a preeminent value investor speaking alongside Warren Buffett at the 2004 Berkshire Hathaway annual meeting, is quoted as saying, “The idea of excessive diversification is madness. … Almost all good investments will involve relatively low diversification.”
  • Nondiversified value portfolios are penalized?

As I’ve pointed out, it is unclear that tracking error, bid/ask ratios and diversification should be criteria for selecting a value investing fund or ETF.

Just how much value do these value funds have?

To assess how much “value” is in these value ETFs, we can run a simple factor analysis. To keep things easy, we’ll focus on the classic 3-factor Fama-French analysis. This analysis focuses on assessing a strategy’s exposure to the broad market (RM-rf), small-cap stocks (SMB) and value-stocks (HML).

First, a benchmark for value, or HML exposure, from Ken French’s website (data here):

  • VAL_10 = top-decile, market-weighted value portfolio

And the associated factor model analysis. Note the HML factor loading of ~0.9 from Jan. 2011 through Dec. 2014.

GrayETFs1

I ran some quick stats in PortfolioVisualizer.com to see just how much value these so-called value investing ETFs identified by U.S. News actually had.

GrayETFs2

The answer?

Not much value to be had. But plenty of closet-indexing.

HML betas are all roughly 0.2 to 0.3, a far cry from the basic VAL 10 portfolio.

GrayETFs3

What’s the main point? Avoid U.S. News when assessing which “value funds” are the best fit for your portfolio. (Duh!) Unless, of course, you value low-tracking error passive market exposures wrapped in a more expensive wrapper entitled “value fund.”

Editor’s note: The original version of this article first appeared on AlphaArchitect.com on Feb. 16, 2015.

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees.

This information is not intended to, and does not relate specifically to any investment strategy or product that Alpha Architect offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

The results in the above analyses are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

 

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